The financial aid arms race at law schools

FORTUNE — As law schools open their doors this month, they are expecting the smallest class of students since the 1970s. The drop in student numbers means fewer student loans, which could dent law school coffers by almost $500 million, according to some calculations.

To stanch the losses, law schools are taking steps including moving back application deadlines, reducing class size, paring faculty and — most importantly — offering more financial aid or full tuition rides to lure prospective students.

But law schools are in a bind. They are sifting through a smaller pool of applicants, making it harder to enroll students with sufficiently impressive grade point averages and law board scores — key elements that undergird their place in the national law school rankings.

With law school applications dropping more than 18% for the 2013-14 class over last year’s — according to figures from the Law School Admissions Council — law school hopefuls are bargaining as never before for financial aid to defray the significant costs of three years of legal education.

Students with solid but not spectacular test scores are reporting that they have full-tuition offers from schools like Washington University School of Law in St. Louis and Vanderbilt Law School — which are just shy of $50,000 a year for tuition.

“I bounced offers back and forth, and eventually I got a full ride,” says Mark Kettlewell, 32, who is enrolling in Washington University. “There is enough information out there to be able to conduct this like a negotiation.

“Like any negotiation, though,” he warns, “the only real play is that you are willing to walk away.”

Kettlewell, who worked in construction before deciding to become a lawyer, persuaded Washington University to increase its initial offer, and later to top it off at three fully paid years — a total of more than $145,000, not counting living expenses.

He says he counted on his law school admission (LSAT) test score, which was 166 (out of a possible 180), to seal any financial deal because it was the same as the median score for last year’s class. Washington University is No. 19 in the U.S. News & World Report ranking of law schools (the same position it held last year).

The law school, says Katherine Scannell, an associate dean, cannot provide any information about the incoming class until October. She expects the class to be only “slightly smaller” than the 201 students admitted last year for a 2015 graduation, she noted in an e-mail. However, at a recent student welcoming session, the law school said professors had turned in their salary increases for the coming year to the scholarship fund, Kettlewell says.

Other students, who asked not to be named, said they had engaged in serious bargaining with multiple schools to come up with the best offer.

“What it comes down to,” concludes another student who also landed three years paid tuition at Washington University law school, “is that one or two points on your law school scores makes the difference not only in being accepted, but also in how much debt you accumulate.”

Law schools, says Michael Spivey, a law school admissions consultant in Boulder, Colo., are feeling the squeeze from the shrinking numbers of applicants.

“In the go-go years, it was easy for the law schools to get the numbers,” he says. “Now clients are being accepted to law schools they could never get in before. But law schools also are doing everything they can to make sure every applicant maintains the school’s ranking.”

Potential students say they are examining their employment prospects before they commit to law school debt loads that can easily hit $150,000 to $200,000.

Nine months after the 2012 class graduated, only 56.2% of law school graduates had full-time legal jobs that required passing a bar exam, according to figures from the ABA. And starting salaries of such students dropped by about one-fifth between 2009 and 2012, according to data from the National Association of Law Placement (NALP), which tracks the numbers.

The law school predicament was debated at the ABA’s annual meeting in recent days. Among the proposals are to give law schools a one-month reprieve on employment reporting for recent graduates, and to weaken teacher tenure, but the 34-page task force report to the ABA’s Section on Legal Education, which oversees accreditation of 201 law schools, focused on steps rather than a sweeping overhaul, and scolded the media for undermining the legal profession.

Some law schools are taking other steps to better inform prospective students. A consortium of 28 schools in May created a website to enable users to search and compare legal jobs data from several sources. One concern about transparency has been a practice by some institutions to fund short-term jobs for recent graduates to raise their post-grad employment numbers.

So far, efforts to hold law schools accountable for alleged misrepresentations of employment have failed. Last month, a federal appeals court upheld the lower-court dismissal of a suit seeking $300 million by a dozen graduates of Thomas M. Cooley law school in Michigan who struggled in the job market after receiving their juris doctor degree.

They argued, unsuccessfully, that the law school had wrongly claimed that 76% of its graduates were employed nine months after graduation and earning an average salary of nearly $55,000. Similar law suits in Illinois and New York also have been tossed out by judges, but there are still pending suits against several law schools in California.

While employment prospects continue to fluctuate, a study released in July by NALP found a modest uptick in legal hiring. However, critics note that paying off a six-figure student loan is a greater challenge when employed for $50,000 or less per year rather than the $160,000 gold-ring, but increasingly scarce, entry position at a major law firm.

As aspiring students become more aware of problematic employment, students are increasingly striving to get the upper hand in shaping their future — at least in terms of debt.

“The schools need students for the revenue,” says Kyle McEntee, who founded the legal education group Law School Transparency, which has been working with some 100 law schools to meet new ABA standards for employment data on school websites.

McEntee calculates that during the last academic year, students borrowed $4.88 billion in federal student loans. He expects that to drop as much as $480 million in the coming 2013-14 academic year, dealing a setback to law school finances.

“The federal government is significantly invested in law school education,” he maintains. McEntee favors the elimination of graduate student loans that fund all school costs, and limits for private school loans, and believes this will likely decrease the cost of a law degree.

With shakier finances, law schools have adopted a variety of tactics, including transferring more students from other law schools to replenish their student ranks, or extending deadlines to allow potential students to take the national entrance exam as late as June and still start law school this month.

To offset the six-figure tuition costs — which do not include living expenses — schools are doling out more grants and scholarships to students, according to the ABA’s legal education section.

In the last school year, the schools gave out nearly $1 billion in such financial aid, a figure that has grown every year, particularly since 2007 when just over $721 million was dispensed.

Spivey, a former Vanderbilt Law School admissions officer, predicts that “law schools will take the tuition hit to preserve their rankings.”

William Henderson, an Indiana University law professor who has studied law school economics, predicts that the approach for law schools will be to “‘hunker down, trim enrollment and costs, and ride out the storm.’

“Odds are good that when the shrinking stops,” he wrote on a law professors blog after attending a meeting of the ABA legal education task force earlier this year, that “law schools will look pretty much the same as they do today, only more expensive.”

In which case, bargaining skills will come in handy.

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